This article was originally published as 11 key tax M&A considerations for the technology industry.
Technology businesses continue to strive for innovation while increasing value and driving growth. As these companies consider potential transactions or an initial public offering, they need to prepare for the challenges involved.
If the company’s exit strategy is a sale, business structure can significantly affect the net-of-tax cash proceeds the seller receives. Prior to seeking buyers and entering into a due diligence process, a seller should also consider which tax benefits each side would receive from the transaction and determine whether tax risks have been property evaluated.
To that end, we’ve compiled some important tax-related factors that all technology organizations need to consider ahead of a potential transaction.
1. Identification and resolution of historical income tax liabilities
Sellers need to be aware of their possible tax risks. Not knowing their tax exposures before the sale could lead to surprises during the diligence process, potentially causing delays or, at worst, undoing the entire transaction. Companies should review their overall tax landscape, including federal and state income tax, sales and use tax, franchise tax, payroll tax, property tax, and international tax, if applicable.
Identifying exposures beforehand enables sellers to initiate remediation efforts before buyers conduct their own diligence. In addition, sellers should prepare sell-side tax diligence reports, which are a valuable tool to share with prospective buyers, resulting in a more efficient sales process.
2. Presale structuring
Technology companies considering a sale should understand the current tax structure of the business and model the specific tax consequences in the event of a transaction. This will help identify optimal structures that could maximize the seller’s post-tax cash proceeds.
3. Tax attributes
Quantifying a company’s tax attributes in a transaction is something technology companies often do not initially consider doing. But research credits and net operating loss carryovers, though they can be valuable assets, may be limited in a transaction. Companies that have generated tax losses often don’t want to spend money for research studies to quantify the tax credits that may be available. In addition, these companies may have undergone changes in their equity structure over time that could limit the net operating losses and tax credits available post-transaction. It is important for both the sellers and buyers to understand what tax attributes exist, and the availability of those attributes after a transaction.
4. Section 382 limitations
Internal Revenue Code section 382 limits the ability of a corporation to utilize net operating losses or other tax attributes following an ownership change. An ownership change occurs when there is a greater-than-50% increase in ownership by 5% shareholders during a testing period, which occurs anytime there is an owner shift or equity structure shift.
These shifts include purchases or dispositions of stock, redemptions and recapitalizations, stock issuances, and various other transactions. The section 382 annual base limitation is generally the product of the value of a company’s equity immediately before an ownership change (subject to adjustment), multiplied by an interest rate published monthly by the Internal Revenue Service.
Buyers should consider any historical section 382 limitations on a company’s attributes as well as any potential limitations that the potential transaction may trigger.
5. Deferred revenue
For financial statement purposes, technology companies have adopted the Accounting Standards Codification Topic 606 guidance to recognizing revenue, by depicting the transfer of goods or services to customers in an amount that reflects consideration to which the company expects to be entitled in exchange for those goods or services.
This adoption has led many technology companies to review their accounting methods for tax purposes as well. For U.S. federal tax purposes, the IRS and Treasury released final regulations to determine the timing of income recognition for taxpayers using the accrual method under IRC sections 451(b) and 451(c), which apply to years beginning on or after Jan. 1, 2021.
Under IRC section 451(c), a taxpayer is generally allowed to defer (to the next succeeding taxable year) the inclusion of advance payments in gross income for federal income tax purposes to the extent the advance payments are not recognized in revenue in the taxable year of receipt. Companies can defer revenue in a manner consistent with generally accepted accounting practices in year one, and the remaining balance would be recognized in the succeeding tax year. In addition, under IRC section 451(b), all revenue for tax purposes shall be recognized into income no later than when included in the company’s applicable financial statements.
Organizations should closely review these points and other regulations around the timing of income recognition prior to a potential transaction to ensure the target company is on a proper tax accounting method, as this can affect a buyer post-acquisition. Depending on the structure of the sale, certain transactions may also result in the immediate recognition of all previously deferred revenue, such as when a transaction results in the company ceasing to exist or joining a consolidated C corporation.
6. Section 174 research and development expenditures
The Tax Cuts and Jobs Act included amendments to IRC section 174. For tax years beginning on or after Jan. 1, 2022, taxpayers will no longer be allowed an immediate deduction for research and development expenditures, including those related to internally developed software. Taxpayers will be required to capitalize and amortize these costs over either a five- or 15-year period, depending on whether the expenses were incurred in the United States or in foreign jurisdictions, respectively. Taxpayers that have historically elected to immediately deduct R&D expenses will need to make a change in their tax accounting methodology.
From an M&A perspective, it is important for buyers to review the R&D expenses of potential targets and understand the tax implications of the new section 174 rules, which will require ultimately capitalizing these expenses going forward.
7. Section 280G (golden parachute payments) analysis
Technology companies structured as C corporations must consider the change-in-control provisions under IRC section 280G when anticipating a transaction. Golden parachute payments are meant to provide management with a soft landing when their company has a change-in-control event.
When a change in control occurs, section 280G limits the corporation's deductions for excess parachute payments, and an excise tax could be imposed on the individual recipients of the payments based on the amount of any excess parachute payment received. A section 280G analysis determines (1) if excess parachute payments exist, (2) the section 280G deduction limitation, and (3) potential excise taxes applicable to disqualified individuals receiving change-in-control payments.
Private companies can avoid adverse tax consequences by taking certain actions and securing shareholder approval of the excess parachute payments through a shareholder vote. However, companies that may undergo a transaction must still complete a section 280G analysis to support the required actions and disclosures.
8. Credits and incentives
Technology companies, particularly in the software development realm, may generate estimated R&D tax credits yearly even if they haven’t completed any formal studies. These companies should consider performing an R&D tax credit study to document and support the historical federal and state research tax credits that could be valuable to a potential buyer.
Companies considering M&A activity should also review their eligibility for state and local credits and incentives—such as sales and use tax exemptions and refunds, opportunity zones and capital investment credits—that could create more value to a buyer.
9. Sales and use taxes
Historically, software businesses required physical presence in a state to have sales tax nexus. The 2018 U.S. Supreme Court’s decision in South Dakota v. Wayfair set a new precedent for economic nexus that no longer requires physical presence. The Wayfair decision will have a far-reaching impact on technology businesses, as states will be able to assert economic nexus over the industry; some states already have economic nexus sales tax provisions in place.
In addition to nexus consideration, the taxability and classification of technology products, including digital goods and services, is an ever-evolving topic. Taxability for digital goods and services versus tangible products can be complicated and hinge on a variety of factors. In addition, tax treatment differs greatly among states. Sales and income tax nexus, including whether technology products are subject to sales and use tax, has become one of the more significant areas of exposure in the diligence process.
10. Transaction costs
Companies can incur significant expenses in connection with a transaction. It takes both planning and proper analysis for a party to maximize the tax benefits from transaction costs incurred, including a determination of which party receives the benefit of any costs.
When a company engages in a transaction, the IRS requires capitalization of the costs incurred to facilitate the transaction. With stock transactions, these costs are capitalized into stock basis and are not recoverable until the stock is sold.
Alternatively, with asset transactions, these costs are capitalized and generally amortized over 15 years on a straight-line basis. In contrast, costs that do not facilitate a transaction can generally be deducted as incurred or be amortized over 15 years.
By performing a transaction cost analysis, a company can identify nonfacilitative costs and maximize tax deductions. Without proper documentation, all costs must be capitalized, and no immediate tax deductions can be recognized.
11. International presence
Many companies in the technology industry have an international presence to reach customers outside of the United States. Companies should review their international presence before a potential transaction and understand the company’s position, and potential exposures, in the following areas: cross-border employees, foreign earnings and profits, including tax pools, permanent establishment, subpart F and cash repatriation strategies, transfer pricing, withholding taxes, and foreign bank account reporting.
12. Worker misclassification
Technology companies often employ independent contractors in areas such as sales and software development. Businesses often prefer to shift the responsibility for payroll taxes and employee benefits to their workers to save money and lessen the company’s administrative burden.
However, the IRS closely reviews worker classifications (such as employee vs. independent contractor), and businesses need to review their independent contractor agreements to ensure their workers are properly classified. It is important that independent contractors not be treated as employees in regard to payroll taxes and benefits.
13. Abandoned and unclaimed property
Unclaimed property is defined as any tangible or intangible property held, issued or owned by a company in the course of its business that has remained unclaimed by the rightful owner for a specific period of time (a dormancy period). Unclaimed property can be in the form of outstanding transactions such as accounts payable, accounts receivable, payroll checks, customer and credit balances, or escheat, and is not a tax.
There is no statute of limitations for unclaimed property unless a state enacts special legislation. This ultimately means a state unclaimed property audit could potentially go back 20 years, allowing the state to determine a year of exposure and extrapolate that exposure over an extended period, as many companies do not keep the appropriate records. Voluntary disclosure programs are available for companies to enter into prior to a transaction to rectify any potential exposures that arise in this area.
If your technology company is considering a transaction or an initial public offering, the tax implications of the sale should not be overlooked. Teams should perform proper due diligence to maximize value.